Not-for-profit organizations that file IRS Form 990 must indicate the number of independent voting members or directors of the governing body. (This is entered on Parts 1 and VI.) The IRS is not the only group interested in these facts. Two other groups also focus on the number of independent directors: state attorneys general and prospective donors. All three groups believe that independent directors are the cornerstone of good governance. In other words, they believe independent directors are less likely to cause the organization to violate prohibitions on private benefit and private inurement.

No Conflict of Interest

Independence generally requires that a director has no conflict of interest. A conflict arises when a director (or a family member) has an interest different from that of the exempt organization (EO). It may involve direct or indirect compensation from the EO, or involve a transaction between the director and the EO or a related organization.

Four Characteristics of Independence

A director is independent only if all four of the following criteria applied at all times during the year.

1. Employee Compensation. The director wasn't compensated as an officer or other employee of the exempt organization or of a related organization. In addition, the director wasn't compensated by an unrelated organization or individual for services to the organization or a related organization, if the compensation is required to be reported on Form 990 (in Part VII, Section A). However, reasonable compensation from the organization for services as a director doesn't preclude independence.

2. Services as an Independent Contractor. The director didn't receive more than $10,000 of total compensation or other payments as an independent contractor from exempt organization (or a related organization). The threshold of $10,000 is based on the organization's tax year. Note: Expense reimbursements under an accountable plan aren't included in calculating the limit of $10,000.

For example, during the exempt organization's tax year, a director received $7,500 in fees for tax and accounting services provided to the exempt organization, $3,100 for out-of-pocket expenses, and a $7,300 fee (considered reasonable) for services as director. The director is independent since the accounting and tax service fees are under the $10,000 threshold and the other items are excluded.

3. Transactions with the Organization. The director (or one of his or her family members) wasn't involved in a transaction with the exempt organization (directly or indirectly through an affiliated organization) , which is required to be reported on the organization's Schedule L, Transactions with Interested Persons, for the current tax year.

4. Related-Party Transactions. The director (or one of his or her family members) wasn't involved in a direct or indirect transaction with a taxable or tax-exempt organization, which is related to the organization — if that transaction is required to be reported on
Schedule L filed by the related organization.

For example, a director is a voting member of the governing body of both Charity A and Charity B, which are related organizations. During A's taxable year, the director's daughter received $40,000 in taxable compensation as an employee of B. The director is not an independent member of A's board because the daughter received compensation from an organization related to the director, and the compensation was of a type (compensation to a family member of a director of B) and amount (above $10,000) that would be reportable on Schedule L if B were required to file Schedule L.

Another example: A director is a voting member of Charity A's governing body. In addition, the director is also a partner with a profits and capital interest greater than 5 percent in a law firm. During A's taxable year, A paid the law firm $115,000 for litigation services. The transaction between A and the law firm must be reported on A's Schedule L because it is a transaction between A and an entity in which the director is a more-than-5% owner, and because the payment by A exceeded $100,000. Therefore, the director is not independent because A's payment of the legal fees is deemed an indirect business transaction with D.

A variation on the above example: If a director was an employee of the law firm (rather than a more-than-5-percent owner) and not an officer or director of the law firm, then A's payment of legal fees would not affect the director's status as an independent director of A.

Tax Court Rulings

The U.S. Tax Court has, in at least two cases, discussed the importance of an independent board to provide operational oversight to an exempt organization. In one case, an exemption was denied because a college scholarship fund organization couldn't show it "was operated exclusively for exempt purposes." The organization primarily raised money from the operation of bingo games at an Iowa for-profit lounge.

The organization's board of directors was comprised of five members. The court noted the initial directors, named in the articles of incorporation, were two owners of the lounge; the lounge's accountant and director, and two other persons, each described as a "bingo player."

The court stated that it appeared "that more than an insubstantial purpose of the (organization's) activities was to attract persons, by the way of the bingo games, onto the premises" of the lounge "expecting that they would purchase food and beverages while participating in the games." The court added that the activities "were, in substantial part, designed to enhance the profitability" of the lounge. (P.L.L. Scholarship Fund v. Commissioner, 82 T.C. 196)

In another case, the court upheld the IRS's determination that the organization was not tax-exempt because it did not, among other things, have an independent governing body. One individual was the organization's president, secretary, sole officer, director and employee. (The Council for Education v. Commissioner, T.C. Memo 2013-283)

However, in both of these Tax Court cases described above, there were other factors that were prejudicial to an exemption under Internal Revenue Code Section 501(c)(3). So it's not clear how much weight the court placed on the absence of an independent board.

Not All Activities Cause Problems

Certain transactions or activities specifically don't compromise the independence of a director. A director does not give up independent status by making donations to the exempt organization, regardless of the contribution amount. In addition, directors don't lack independence simply because they are part of the governing body of another charity that received funding from the exempt organization during the organization's tax year.

Also, a director is permitted to receive financial benefits from the exempt organization solely by virtue of being a member of the class served by the organization in the exercise of its exempt purpose, provided the financial benefits comply with the terms of membership of the organization.

Finally, a director who has taken a bona fide vow of poverty isn't considered to lack independence because he or she either:

Receives compensation as an agent of a religious order or a Section 501(d) organization, provided the compensation is not taxable; or

Belongs to a religious order that receives payments from the exempt organization that are not taxable income to the member.

Keep in mind: An organization must make a reasonable effort to determine the independence of its directors. One way to do this is to provide a questionnaire annually to each director and reasonably rely on each person's responses. Of course, if your board knows facts that contradict a director's response, it would preclude relying on the response.